Sunday, November 8, 2009

International trade

In this article I’m going to briefly touch on the implications of international trade and try to clear up some of the confuse that exists concerning our exporting, importing, unemployment, and income. To do this I’ll use simplified examples but the simplification is a way to establish the principles and these principles can be expanded to the actual process. In other words, I’ll establish something similar to why 2+2=4 and this process can be applied to adding a million numbers together. There are just two many “things” being traded to deal with them all at the same time so I’ll simplify and use just a few traded items in my examples. Furthermore, I ask that you finish reading all of it before you start posting questions are comments since the questions that are raised for you in one paragraph, I hoped to have answered in another paragraph.The most important implication of trade whether it is between two individuals, two companies, or two countries is the fact that both must benefit or trade will not occur. This should be an obvious concept since neither you, me, nor anyone else is going to trade to be worse off than before the trade. There are just not enough unintelligent people of this sort for this to occur. It is irrational and we are rational beings. Now, it is a pretty simple concept for what we trade between two people, for example, I have a baseball bat and you have a football we exchange because we value what the other has more than what we have. We both benefit. We are both now better off. Our wealth has increased because we both have something we value more. The question of how two countries trade is a bigger concept but the very same principle. It was discovered about 200 years ago by David Ricardo. It is called the Law of Comparative Advantage. Here is what it says: One country is said to have a comparative advantage over another in the production of a particular good relative to other goods if it produces that good less inefficiently than it produces other goods, as compared with the other country.What Mr. Ricardo said is 100% true, yet most people don’t understand what it is he said exactly. An economist might decipher this but we need for everyone to understand. So here goes. Let’s look at an example and see if we can clear things up for us regular people. An investment broker has to fill out a lot of forms and hires an assistant to do this typing and paper work. The investment broker discovers that she can type faster and complete the forms faster than her assistant. She is more efficient at this than her assistant is but it is not likely that she will fire her assistant and start doing the typing herself. Her good judgment tells her that although she is a more efficient at typing, it is much more lucrative for her to concentrate on clients. The opportunity cost of an hour with clients is much more efficient than the hour she would devote to typing. Precisely, the same principle applies to two nations. Even if one of them is more efficient than the other in producing everything. Being more efficient producing everything is an absolute advantage but trade is based on comparative advantage. The USA maybe more efficient at typing and producing all goods than China but still benefit from trading with China or vice versa. When every country does what it does best, all countries can benefit because more of every commodity can be produced without increasing the amounts of labor and other resources used. Let’s look at the arithmetic of comparative advantage.To keep it simple we’ll say the only input is labor, remember what I said in the beginning about 2+2=4, We’ll say China has an absolute advantage in producing TVs and computers, in other words, one year of labor they produce 50 TVs and 50 computers, While the US with one year of labor produces 40TVs and 10 computers. So China is a more efficient producer of both goods. I apologize that this forum does not show charts very well or I would produce one. None the less, it pays for China to produce computers and trade with the US for TVs even though China produces more of each. We see that China produces 50 TVs to the US’s 40 TVs so China is 25% more efficient producing TVs than the US with a years worth of labor. However, China is 5 times more efficient at producing computers than the US, 50 computers to 10 computers. China has a comparative advantage in computers. Their competitive edge is far greater in computers.From the US perspective, we are more efficient producing TVs than we are producing computers. According to Ricardo, both countries can gain by specializing; Thus China should produce computers and the US should produce TVs and the two countries trade. Let’s verify this. If the US moves 1000 labor hours from producing computers to producing TV’s , then computers go down by 10,000 but TV’s go up by 40,000, so that the US is now producing 0 computers and 80,000 TVs. China would shift 500 labor hours out of TVs and into computers; thus producing 75,000 computers and 25,000TVs. Together the two countries now produce 15,000 more computers and 15,000 more TVs with the same amount of labor. This represents a change in production arrangements so that world production is increased. Trade then produces an increase, a benefit, for both countries. The national income of both countries rises. They are both wealthier by trading.Something that should be clear from this example is that stopping imports and using domestic production can not create the gains of 15,000 more TVs and 15,000 more computers. It would only lower the standard of living for both countries and reduce their national incomes by using domestic production only. What does this 2+2=4 process tell us about trade that involves millions of goods and services between the US and China? It tells us that China has a comparative advantage in labor and we have a comparative advantage in capital; thus we are trading capital for their labor. Let’s go back to the investment broker for a moment. The greater the difference in what the investment broker makes by spending her time with clients and what she pays her typing assistant the greater the benefit; likewise the greater the difference in wages in the US and China the greater the benefit. I know the question you are thinking. What about all the unemployed it creates in the US and lost income? I’ll get to this in a minute. First, I want to digress and cover the myth or fallacy of cheap labor. If one will think of international trade as proportionate, relative, or comparative then you will avoid the common fallacies of international trade. You will avoid the most dreaded fallacy of all: cheap foreign labor. The argument maybe summarized as follows: It is patently unfair to subject the highly paid American workers to the competition of foreign labor which works for a handful of rice a day. Imports of goods, therefore , which are produced by cheap foreign labor should be restricted to protect our domestic jobs. This is the absolute way of looking at trade. It could be extended in the following absurd way: If all trade is based on the cheapness of labor then it would be impossible for high wage nations to export anything. Exports would have to be produced my workers willing to subsist on less than a handful of rice per day. If countries are willing to sell us products cheaper than we can make them then our standard of living must rise not fall. In the late 1990’s, imports poured into our country yet the unemployment rate was the lowest in a generation. It is our national monetary and fiscal policy that should be blamed for unemployment and not our international trade policies. Remember it is relative and comparative and this explains our trading with China. They have an abundance of labor and we have an abundance of capital. Our trade is based on these relative advantages. Cheap labor will be of little significance in generating hydroelectric power because labor is only a small part of total production costs. Producing bananas requires more than cheap labor or people in Siberia would produce bananas. The cheap labor fallacy fails to see that different products require different factors of production. This thinking can be applied to the reverse about high union wages too.Now we are getting to the part where the readers are wondering how if we are better off with this trade with countries that have cheap foreign labor that all of us seem to be suffering from a lower standard of living right this moment and high unemployment too? We don’t feel all this good stuff you keep telling us about! You see, most of the public has identified the wrong problem and keep asking for a solution to the wrong problem which naturally, will not solve any of our problems. We know from the above that just like the investment broker and just like our trade with China doing these things based on relative, comparative, proportional thinking creates greater gains. Our national income goes up, we have more than we could have had we not traded. The question becomes one of who benefits? Since the US is trading capital for labor with China, then the owners of capital experience a rising income as our national income rises but since these owners of capital are not buying their labor here anymore then the wage earners here experience a declining income as the national income rises. The problem is not one of trade but one of the distributions of the gains from trade. The importing of labor intensive goods is a warning that we must shift our production to capital intensive goods. Not lower our wages because the gains are greater the bigger the differences between our two countries. The public is just as confused about trade and cheap labor as they are about distribution of wealth. They are against any redistribution of wealth because they believe in capitalism and free markets. I believe in capitalism and free markets/trade. It should be apparent from the above trading of capital for labor that free trade/markets between them and us will not change the fact that the owners of capital will get more income and the wage earners here in America will get less income. Also, trade restrictions will only lower the gains from trade for both countries. Additionally, capitalism is about maximizing production with limited resources. Notice that this does not say anything about distributing the gains from maximizing production but for some reason the public equates these two distinct processes, as if by doing one the wealth created somehow automatically ends up with who it should end up with. Distributing the wealth created is not the same as maximizing production with scarce resources. These are not synonymous. It should really be all too obvious to everyone from the statistics that capitalism is a very poor distributor of wealth created in any manner that would be considered distributive justice. What does this indicate going forward for a nation that trades capital for labor and where 10% of the population owns 80% of the stock on the stock market and about this much of all the capital producing assets in America? It indicates that we as a nation need to rethink the “rules of the game” so that there is a more democratic ownership of capital. Listen, we keep asking for jobs. Where are the jobs? What we really want is not jobs but income. If you had plenty of income you wouldn’t need a job, you could buy labor. Remember wages are just one of two ways to earn income, the other being capital. Going forward we know that the US will be trading capital for labor and this suggests that we expand those who own capital but it also, suggests that we move our exports to those things that are capital intensive and we move workers to these areas of production. It is important as this transition occurs that we move smartly to help those displaced by international trade. We must move to easy the disruptions in people’s lives that are affected by these transitions. However, I repeat, that it is our shortcoming in national monetary and fiscal policy that is the cause of high unemployment and not international trade policies. Before I go on to explain about why we don’t need to export more than we import since this would just make us poorer and why this doesn’t happen anyway, I would like to say something about value. The value of something doesn’t change because of what country it is in. In other words, the value of a barrel of oil is the same no matter what country it is in. Perhaps an example would help show this. If I go outside and use a yardstick to measure the height of a tree in my yard and it is 10 yard sticks high and the next day I break the yard stick in half and measure the tree and it is 20 half yardsticks high, the height of the tree did not change. The unit of measure changed. The value of a barrel of oil does not change, just the unit of measure. The purpose of exchange rates is to reflect that the value of a barrel of oil does not change depending on what country it is in. I don’t wish to get bogged down in money and exchange rates in this discussion so I’ll move on to international trade. How do we keep up with this international trade? Well we use accounting; not economics. We use what is referred to as the Balance of Payments. Its accounting and all countries use this accounting regardless of their economic philosophies. We credit this and debit that and at the end of the period; guess what? It balances. That’s right all these transactions of trade whether exporting or importing must balance. They have to equal. It is accounting. I’m going to simplify. All international transactions can be summarized into one of five categories: exchange of merchandise, exchange of services, investment income, transfers, or exchange of financial assets. You see if we are importing more merchandise than we are exporting then we must be doing one of the other four things to make the Balance of Payments balance. This makes sense since transactions must be paid for in some fashion. Credits must equal debits. The balance of payments always and necessarily balances. I know this comes as a surprise to many of you since you are always hear this and that about a deficit or surplus in the balance of payments as if we are precariously about to lose our equilibrium. If we are importing more manufactured goods than we are exporting then that deficit must be offset by a surplus somewhere else. In other words, somewhere we are exporting more than we are importing to create the surplus to offset the deficit in manufactured goods. It is financial assets generally speaking that offsets this manufactured goods deficit. I told you earlier that our country trades capital for labor; the labor in the imported goods. We hear this deficit talk all the time and must ask ourselves from whose point of view? Didn’t the importers want to purchase whatever they purchased? Didn’t the bank want to lend whatever they lent? Didn’t governments want to offer grants abroad? You see, you must question who where the people for whom the results of international trade turned out different from what they intended? When someone says there is a deficit in the balance of payments: Ask them how they know that? Is it the “deficit in the US trade balance”? This has been going on for years. For years we have imported more “ merchandise” in value terms than we exported. But why ignore all the exported services and financial assets. Merchandise, services and financial assets are all valuable to the people who receive them. They want them! The Balance of Payments must balance.We are losing financial assets you might say but that is no more a deficit than to say Japan is experiencing a deficit because they are losing automobiles and TVs. You might say it can’t continue forever and it won’t.

note on the graphs used here

in March a year ago the St Louis Fed, home to the FRED graphs, changed their graphs to an interactive format, which apparently necessitated eliminating some of the incompatible options which we had used in creating our static graphs before then...as a result, many of the FRED graphs we've included on this website previous to that date, all of which were all created and stored at the FRED site and which we'd always hyperlinked back there, were reformatted, which in many cases changed our bar graphs to line graphs, and some cases rendered them unreadable... however, you can still click the text links we've always used in referring to them to view versions of our graphs as interactive graphs on the FRED site, or in the case where an older graph has gone missing, click on the blank space where it had been in order to view it in the new format....